Thursday, February 21, 2013

Linn Energy per flowing barrel

A fairly standard oil-and-gas valuation metric is the price per flowing barrel for oil and gas.

Oil at $100,000 per daily flowing barrel is considered high end - but some transactions happen at higher prices when there are further development opportunities in the field and the oil is light, sweet crude.

Flowing gas (per BTU) is typically worth about half flowing oil. [Use a conversion that 6 Mcf of gas is equivalent to about 1 barrel of oil]. So lets call this $50,000 per flowing barrel equivalent.

Natural gas liquids trade at about half the price of oil - and so a flowing barrel should be worth about half a flowing barrel of oil. Also lets call this $50,000 per flowing barrel equivalent.

These are fairly standard metrics and any oil and gas analyst should be able to confirm that I am not rigging the numbers here.

Linn Energy per flowing barrel

Here - from the last form 10-Q is the average daily production of Linn Energy for the last quarter by different types of hydrocarbon:

Three Months EndedSeptember 30,

2012

2011

Variance

Average daily production:

Natural gas (MMcf/d)

409

170

141

%

Oil (MBbls/d)

30.8

22.6

36

%

NGL (MBbls/d)

31.4

12.2

157

%

Total (MMcfe/d)

782

379

106

%

The increase is not driven by field development but by buying almost $2.5 billion in new assets.

Using the metrics above:

The gas production is worth 409,000*$50,000/6 = $3.41 billion.

The oil production is worth 30,800*$100,000 = 3.08 billion and

The NGL production is worth 31,400*$50,000= 1.59 billion

The total valuation of the hydrocarbons is thus 8.08 billion as per the flows in the last 10-Q.

The last 10-Q also showed LINN as having debt of $6.84 billion in debt. So the equity would be worth 1.24 billion.

There were 199 million units outstanding as per the last 10Q. This gives an equity valuation of $6.22 per unit - a fair bit lower than the current price of $36.65 per unit. Longs can expect an 80 percent loss on their units using these valuations.

My view is that Linn Energy's gas and oil fields are pretty clapped out - and worth considerably less than the above metrics. The average well flows about 6 barrels per day! [My personal view: the debt will be impaired.]

However even at a full price this MLP is worth under $7 per unit.

To be fair though - this company has purchased a lot of in-the-money options and its option position is valuable. The value of those is about $900 million - which is almost $4 more per unit.

To get anything like the price targets of the bullish analysts are putting on it you need to think these clapped out assets are worth $200,000 per flowing barrel.

I know, I know you object: MLPs are not valued on their underlying assets. They are valued on their yield.

Well you can compare with other mature wells. The reserve data don't look too out-of-whack. Yes the production cost is high but the development cost is lower. And production cost is only incurred when you produce, unlike development has to be put in up front. Based on year end 2011 reserve data, the undiscounted net cash flow is about 17B while PV10 is 6.6B, net debt was 4B. Since their financing cost is lower than 10%, they were worth some what more than 2.6B and a lot less than 13B (0% financing cost and 0% expected return).

nice metrics. do they apply to (small) private market transactions? if so, do the same values apply to public entities? after all, the whole point of a roll up is that the same assets put in a public corp are valued differently and priced higher because they are now investable by the general public which does not need to operate the asset/get hands dirty. in a sense, I suppose, all public corps are sold on yield (though it is sometimes called P/e)?

Your gas metrics are off, 6:1 is the btu equivalent ratio, not (for US gas) the economic ratio, which in today's spot market is 30:1. More broadly, flowing barrel valuation metrics are very misleading and commonly misused, even within the industry. They contain a lot of assumptions about decline rates and non-PDP assets that can vary dramatically from field to field. Note that Linn targets mature fields (hence the stripper wells) which would imply very low <7% declines and high PDP/Non-PDP ratios. Their metrics will look very different from many big name E&P peers, simply based on the assets (pre financial engineering)

Linn trades at $18,000/Mcfe/d, which is right in line with other top quality E&P MLPs such as EV Energy Partners ($17,500), Legacy Reserves ($19,000), Pioneer Southwest ($12,000) and QR Energy ($18,500). Linn also trades at roughly 7x 2013E EBITDA which is the median number for the rest of the group. The valuation is inline and their yield is actually one of the lowest of the comp set. You can't value public MLPs off of private transaction comps ($100k per flowing barrel) that you pull out of thin air. It's not the same thing. Not to mention you didn't even reference what transactions you were referring to to get your $100k per flowing barrel metric. You just threw those numbers out there and called them "standard oil and gas valuation metrics." Linn also has 5 Tcfe of proved reserves and nearly $9 billion of PV-10 value...I think that underpins their value pretty well

LINN Energy (LINE), LinnCo, LLC (LNCO) to Acquire Berry Petroleum (BRY) in $4.3B Deal"This transaction creates tremendous value for LINN Energy, LinnCo and Berry equityholders. We are pleased to have been able to use our massively overvalued stock to purchase some real earnings power," said Mark E. Ellis, Chairman, President and Chief Executive Officer, LINN Energy. "Because Berry's financials do not overstate earnings by 100%, we believe this transaction generates significant accretion to our distributable cash flow per unit."

(In case you didn't notice, I modified the quote.)

This is the problem with shorting companies that are (a) merely overvalued due to accounting shenanigans rather than due to some coming real-world events, and (b) serial stock issuers. There are enough ignorant/lazy buyers to keep overpaying for the stock, and the company creates real shareholder value every time it issues more overvalued stock, either directly or through acquisitions. See, e.g., Einhorn's nemesis Allied Capital.

Risks:"We will incur corporate income tax liabilities on income allocated to us by LINN with respect to LINN units we own, WHICH MAY BE SUBSTANTIAL."

"Why does LINN believe that LinnCo will enhance LINN’s ability to raise equity?

LinnCo will be taxed as a corporation, which will enable holders of LinnCo shares to invest indirectly in LINN without the associated tax-related obligations of owning a LINN unit"

"Tax Risks to Shareholders • If LINN were subject to a material amount of entity-level income taxes or similar taxes, whether as a result of being treated as a corporation for U.S. federal income tax purposes or otherwise, the value of LINN units would be substantially reduced and, as a result, the value of our shares could be substantially reduced."

"Our federal taxable income will be subject to a corporate level tax at a maximum rate of 35%, under current law (and a 20% alternative minimum tax on our alternative minimum taxable income in certain cases), and we may be liable for state income taxes at varying rates in states in which LINN operates."

In other words, if LINN makes money someday, the LNCO dividend gets whacked by taxes! Berry shareholders are so screwed.

Emphasize again, BRY shareholders are getting screwed in part because they are being acquired by a C-Corp called LNCO that is trading at a premium to MLP multiples! BRY is NOT being acquired by an MLP.

You and yours pals at Foundation have already been caught in lies. Just give it up, the jig is over. I hope you have conviction to stay short a long time, because it's going to be a long, painful ride paying that monthly distribution while watching the price go up.

Even the shill, junior analyst you guys tricked from Weill who has no energy background raised his target today.

Do you really think Leon Cooperman has held this stock as a top holding since late 2007 and doesn't know its accounting inside and out. His representative on the conference call was very happy.

"Linn also trades at roughly 7x 2013E EBITDA which is the median number for the rest of the group."

That was questioned in an earlier blog post and I think that question still stands. What is the reason that a company buys mature wells for $1 and immediately adds $2 to its market value (trades 2x bv)? Does it have lower operating cost? Financing cost? Even if the financing cost is lower you will still need a lot of leverage to achieve that kind of value. However it does appear that as of end of 2011 lenders were not at great risk.

John,

I think your previous picture of mature wells may be off. BBEP has wells in California that has been pumping for close to 100 years now. Production cost is high but there is minimal developing cost. GTP should have all been in place and well depreciated. But BBEP only trades at a (small) discount to book and it was only able to raise equity capital at around book. LINE is a wonder in being able to raise capital cheaply.

"$422 million in asset impairments in 2012 certainly implies that they are overpaying for at least some of their assets.. "

i'm not disputing that - i am not even saying that this is a good company, i hate growth stocks precisely because their cashflow is meaningless, it's always "invested", so no one ever sees the cash, so if they lie, how would you ever know

all i am saying is -- it seems to me that the metric of $$ x flowing b/d in private transactions may not apply to public corp, and vice-versa

so just wanted to know form John whether he thinks that metric applies to public corps or private transactions

Here is something I haven't thought of until today. The Fair Value of the assets Linn is acquiring (indirectly through LNCO or directly) is steadily increasing over the long term. There may be short term declines, but overall the general trend is upward.

So, not taking this into consideration, which GAAP currently does not, will materially misrepresent Linn's asset valuations, its net income, and its equity over the long term, IMO. That, IMO, has been left out of the equation with those, including me, who have argued that Linn's Earnings are not adequate.

With the increase in valuation of assets owned, this adds to Net income and Net Worth over time, which is not currently reflected in the GAAP financials. This makes any financial ratios using these GAAP elements of the financials materially wrong, IMO.

Understanding LinnCo (LNCO) is critical to understanding the scam going on here.

MLPs are good investments for people with certain tax situations, especially if they are in a low personal tax bracket. Linn Energy (LINN) did well issuing shares to these people. But the number of people who want to invest in MLPs is limited by the K-1 forms, and unrelated business tax income UBTI assessed on IRAs and pension funds. LINN got too big to continue to issue shares into the MLP space.

So LINN invented LNCO. LNCO is a corporate shell that owns LINN on a one-to-one basis, pays tax on LINN distributions, and passes through the rest. Right now, the tax payments are de minimus, because LINN has virtually no GAAP income.

In the future, *if* LINN has GAAP income, LNCO will pay hefty 35% taxes and will pay a much lower dividend than LINN. LNCO shares will crater if that happens. According to the S-1, LNCO could then be dissolved by distributing the LINN shares to LNCO holders. But everyone who owns LNCO does so because it is inappropriate for them to own an MLP like LINN, therefore all will sell.

The big fraud here is convincing people they can have an MLP distribution inside a corporate shell. They can't, at least not if they are profitable from a tax accounting standpoint. Everyone who is buying LNCO is buying an investment that is unsuitable for their personal situation. But duping these people into LNCO is essential to keeping the perpetual share issuance machine going.

You've done great follow-up analysis regarding the hedging and non-GAAP issues, and you got me really fired up on the short side, but I think your enthusiasm may need to be tempered. First, flowing barrel metrics and reserve valuation metrics are a joke. They tell you nothing of the real economic value because they don't even attempt to adjust for decline curves, operating costs, basis differentials, etc. You should look at PV-10 value as a decent floor for valuation.. unless you want to call fraud on their reserve engineers (essentially the credit agencies of the energy world). Assuming the independent reserve engineers are doing an ok job, let's ignore the BRY aquisition and look at the year-end 2012 results:

Page 11: LINE has $4.4b of book value and $6b of debt (we'll say zero net working capital). That's ~$20/share of book value. And while you can argue about LINE is overpaying for acquisitions, they only win 20-35% of the acquisitions they bid for. I'd argue energy M&A is a pretty competitive and fair process for whatever the current commodity price environment is. So that's one easy way to think about valuing LINE, the best way for a floor valuation is to look at PV-10. Which on page 18 is $7.8b (including their attractive hedge position, which they may have paid for upfront, but still has $1.7b worth of current value). So haircut the $7.8b by $6b of debt and you get $2.8b, or $12.30/unit, down ~66% from current levels. BUT, there are other things that need to be considered. 1) Over 50% of production is nat gas, which was valued using the average of 2012 prices, which almost everyone with energy common sense would argue is unsustainably low. 2) This gives no value for any 2P (probable) or 3P (possible) reserves, which encompass a majority of an E&P companies valuation. LINE has some pretty attractive assets with lots of unbooked potential, and pretty much all their acquisitions have additional upside beyond proved value, which is why LINE likely paid above PV-10 for the packages. Giving them a very conservative 33% 3P upside to PV-10 (most E&P companies are at much higher multiple to PV-10), gets us to $7.8 + 0.33*$7.8 - $6b = $4.4b, and back to book value. $20/share. Real M&A value is likely a decent bit higher given their asset portfolio.

If anyone has any thoughts or critiques on my floor valuations, by all means, please correct me.

Is LINE's goofy-ass CFO, Kolja Rockov (http://media.culturemap.com/cache/1b/39/1b3986074ab5b378f9f42f3c52b68c35.jpg) gaming EBITDA and distributable cash flow to keep the stock high so they can continue to play the arb game? Yes. Is the stock overvalued by 20-40%? I think so. Is there a catalyst that is going to drive this lower? I wish. Is this stock going bankrupt because it's assets are worth less than debt? Very doubtful. Is this an attractive risk/reward short with no catalyst, 20-40% downside, essentially 8% neg rebate, and some decent upside commodity price risk? I don't think so.

$422 million in asset impairments in 2012 certainly implies that they are overpaying for at least some of their assets..

-----------------------------------

That's absolutely not true. That's a function of gas prices falling off a cliff in 2012 and LINE having to take impairments because of ceiling tests. Happened to all E&P companies over last 12 months. If you pay fair value for an asset when gas prices are $4, and gas prices go to $3, you're going to take an impairment. Was it a bad purchase if your long-term view is $4 or higher? No. Has anything about your reserves changed really? Nope.

I haven't done any work here so take my comments with some salt grains, but i really think those of you talking about book value, GAAP, comparable valuations, etc are missing the point and wasting your time.

This short will be about the cash flow statement and nothing else, with the financing section being the most important. John has it right when he says "until the yield stops." As long as the company generates cash, operating or otherwise, the yield yields and uncle Cletus is happy, irrationality frequently trumping solvency as it is wont to do when interest rates scarcely exist.

It's hard to make money on the short side betting on assets converging to their intrinsic or fair value because you have to pay to wait. Timing is to shorting roll ups as image is to Andre Agassi.

That said, every short seller worth his salt has to have a jihad or two in his book just to make life worth living.

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